Debt and Taxes

Miller, Merton H., “Debt and Taxes,” The Journal of Finance, Vol 32, No 2 (1977), 261-275.

Purpose:  To argue that, even if debt repayments are tax deductible, a firm’s value is independent of its capital structure.

Arguments:

  • The [potential] direct bankruptcy costs of debt seem too small to be balanced by the tax savings.
    • Corporations do not have as much debt as models suggest they should have – fear of bankruptcy has to be very high for debt levels in the models to match the empirical evidence.
    • The potential indirect costs of bankruptcy are probably not very big, either.
  • Between the 1920s and the 1950s, taxes increased 400% while corporate capital structures changed very little (and change through the end of the 1970s appears unlikely).
  • Investment bankers and corporate financial officers are aware of the tax implications of debt.
  • The only explanation left is that the tax savings of debt are much smaller than researchers generally believe.

Tax Advantages of Debt:

  • If there are no taxes, there are no tax advantages.
  • If there are corporate taxes but no personal income taxes, then the tax advantage of debt is the corporate tax rate multiplied by corporate debt.
  • If there are personal income taxes, and the personal tax on share income is less than the tax on bond income, then investors will prefer that corporations use equity financing over debt financing, thus negating the tax advantages of debt.
    • Corporations holding very little debt and/or paying small dividends will be preferred by shareholders in high tax brackets.
    • Corporations with high leverage and/or high dividends will be preferred by shareholders in low tax brackets.
    • One shareholder class is as good as another, so capital structure is, again, irrelevant.

The Cost of Capital, Corporation Finance, and the Theory of Investment

Modigliani, Franco, and Merton Miller, 1958, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” The American Economic Review, Vol. 48, No. 3, 261-297.

Purpose:  This paper proposes a theory explaining how a firm’s stock price (market value) is impacted by managers’ capital structure decisions.

Motivation:  Previous work regarding the cost of capital treats assets as having known income streams, and adjusts for uncertainty simply by subtracting “risk discounts” from the expected rates of return.  This treatment of risk is inadequate.  A market-value approach—where the cost of capital is the return on an investment that does not affect a firm’s stock price—has promise, but we need a theory describing the impact of a firm’s capital structure on its market value.

Theory:

  • Model 1:  Corporations can only issue common equity
    • Assume perfect markets, no agency problems, and an economy where all assets are owned by corporations that can only finance operations with common equity.  Therefore, the rate of return on one share equals expected return to the share divided by share price.
      • Since there are no agency problems, retained earnings are the same as cash dividends.
    • Assume classes of corporations where each share’s expected return is perfectly correlated with all others in the class.  Then there is one rate of return for each class, and all shares in a class are perfect substitutes (up to a scale factor).
  • Model 2:  Corporations can issue bonds in addition to common equity
    • Assume bonds trade in perfect markets and all corporations and households have a perfect credit rating.  Then all bonds are perfect substitutes (up to a scale factor), and have the same expected rate of return.
    • Market value is independent of capital structure.
      • If an individual values leverage, he can take it on himself by borrowing money to buy more stock in an unlevered company.
    • The expected rate of return on stock in a levered company is the rate of return on a pure-equity company from its same class, plus a premium equal to the debt-to-equity ratio times the spread between the class-specific equity return and the [universal] cost of debt.
  • Model 3:  Corporate interest payments are tax-deductible
    • The debt-vs-equity consideration is important for overall corporate liquidity management due to taxes, timing, market sentiment, investor tax profiles, etc.
    • However, all that matters in project financing is the cost of capital.  A preference for one type of financing over another does not make a project more or less profitable.

Empirical Evidence and Conclusion:

  • Using data from the only two relevant studies:
    • There is no significant relationship between leverage and cost of capital.
    • As leverage increases, expected return to equity increases.
  • The amount of leverage can be important over the life of a corporation, but is irrelevant in determining the profitability of a project.